Interest rates are rising, and 2013 posted strong performance for equities. These two facts mean that the health of many large U.S. pension systems has improved dramatically. That has implications for the broader health of companies with big pension obligations. Since 2008, economic conditions have been very difficult for pension fund managers, and many funds have been in deficit. That means that as companies looked forward, they had to allocate more of their of cash to meet their pension obligations.
A company whose pension is fully funded has more free cash to use for other purposes — such as expanding capacity, pursuing research and development, buying back shares, or paying dividends. The rebound of America’s big-company pension systems bodes well for the year. One analyst has estimated that improved pension health could add almost a percentage point to earnings-per-share growth for S & P 500 companies in 2014. The chart below tells the story: after the 2008-2009 crisis, companies had to shovel money into their pension plans as interest rates fell and markets underperformed. That trend started to reverse in 2012 (and strengthened its reversion in 2013):
Pension Contributions From S & P 500 Companies
Source: BoA/ML
Better Returns Ahead on Investments
And it’s the improving market — rising rates, better returns from equity investments — that’s driving this picture. When pension fund managers plan how much they need to invest, they assume a “discount rate” — typically the rate of return from a safe corporate bond. And after falling steeply from 2008 to 2012, that rate finally began to rise.
Moody’s AA Corporate Bond Index Yield
Source: BoA/ML
Good News For Pension Providers… and Stock Holders
This trend, we believe, will continue in 2014. Interest rates will rise, and the stock market will continue to perform well — so the health of pensions will continue to improve.
A further side effect of this process is the weighting of pension funds’ investments. As you would predict, during the aftermath of the financial crisis, fund managers weighted fixed-income investments more heavily in their portfolios. Now that equity markets are performing better, that weighting is shifting more towards equities:
Pension Funds Are Shifting to More Equity Allocation, Less Fixed Income
Source: BoA/ML
To us, this means more big institutional money will be flowing into U.S. stocks.
Bullish Data Points
Taken all together, these data points provide an encouraging picture. Healthier pension funds mean more productive companies with more flexible capital structures; possibly more dividend payments, stock buybacks, and productive use of capital; and heavier pension fund equity weightings helping support demand for stocks.
For more commentary or information on Guild Investment Management, please go to guildinvestment.com.
